It’s hard to be an investor, and frankly pretty hard to be alive, without hearing about the latest tech trend – artificial intelligence, or A.I.Spearheaded by the explosive growth of ChatGPT from 2022, AI is now everywhere. AI chatbots from OpenAI, Google, and Microsoft. AI-powered search engines. Cloud software-as-a-service offerings with numerous AI-powered features. AI self-driving vehicles. And, coming very soon, AI-enabled smartphones from the likes of Apple, Google, and Samsung.It’s a huge trend, and investors have been looking for ways to get onboard.At GreenDot Stocks, of course, we do that through checking out stocks on the Green Screens.Since growth is a key component in these screens, there are a handful of stocks that are commonly linked to the AI trend. Many of them (*cough* Nvidia *cough*) are just hyper-valued right now.However, I do think a recent addition to the screen is an excellent way to play the A.I. trend, packaged in a firm that dominates one of the world’s most important industries, with multiple moat factors and great continuing growth prospects. Let’s take a closer look at the Taiwan Semiconductor Manufacturing Corporation, or TSMC (ticker TSM).
The Business of TSMC
A lot of companies design semiconductor chips for a variety of electronics products. Apple designs many of the chips that go into its Macs, iPhones, and iPads. Nvidia designs its own graphics and AI processing chips. Qualcomm designs many of the mobile processors that go into Android smartphones and other handheld devices.But none of these companies want to take on the massive capital expenditures and R&D costs associated with actually *building* those designs! That’s where firms like TSMC come in. They specialize in manufacturing the chip designs provided by these firms, using the very latest in semiconductor technology, at scale, and with the highest quality possible. This is known as the “foundry model”.Firms like Apple and Nvidia contract with TSMC to produce the actual chips that go into their smartphones, computers, graphic processors, and so forth. The device you are reading this on right now likely has numerous chips that were produced at a TSMC fab! The company has some other, smaller, businesses including design services and IP sales, but foundry sales are by far the bulk of revenues.
The Revenue Model
So, does this business model meet the two characteristics we look for – growth potential and recurring sales?It’s hard to think of an industry that has been more transformative to everyday life over the past 30 years than electronics. So much of today’s lifestyle, from social media to streaming video to electric cars (and much more), have been made possible by the steady advance of chip design since the 1980’s. Even older goods like gas vehicles, washing machines, and power tools have been taken over by electronics! There seems to be no end to the potential applications.To wit, TSMC has delivered 18% compound annual revenue growth since listing in 1994. That’s 30 years of nearly 20% compound growth! That kind of performance turns $10,000 into $1.4 million.Growth potential looks as good as ever. AI is a burgeoning new use case for semiconductors, requiring cutting-edge chips that are fast, small, and low-power – exactly what TSMC specializes in. High performance computing applications, Internet of things (IoT), autonomous driving, and language processing are other trends that should drive demand. I see no reason TSMC cannot continue to grow sales at its historical rates, and indeed, management has targeted 15-20% annual sales growth through 2026.Recurring sales is one category where TSMC does not stand out. The semiconductor space is notorious for its rapid product cycles, meaning TSMC has to continually win new contracts from its customers. That said, given the firm’s competitive advantages (which we’ll touch on in the “moat” section below), it seems unlikely to lose a lot of business from its main customers any time soon.
The Moat
This is, at its core, a contract factory for the chip industry. This business model does not lend itself well to some moat characteristics (e.g. switching costs, brand, etc.), but it DOES lend itself well to others.The key moat potential in any factory operation are ECONOMIES OF SCALE – and this firm has those in spades. TSMC is by far the world’s largest dedicated chip maker, with over 60% share of the global foundry market. This is a massive advantage. Fixed costs are very high, so every additional chip that can be produced from that base adds incrementally to gross profit margin. TSMC’s gross margin of 53% dwarfs that of primary competitors UMC (34%), GlobalFoundries (25%), and SMIC (14%).While I don’t recognize it as a truly durable competitive advantage, TSMC has also separated itself from the competition through its technological leadership. While there were 6 foundry firms on the cutting edge of chip technology in 2015, today there are only 2 producing 5nm and smaller chips: TSMC and Samsung. Competitors like UMC and GF have declined to even compete in this space – the technology is too hard and too expensive. As a result, clients that want cutting edge HAVE to come to TSMC.Because of the limited competition in leading technologies, TSMC is able to charge premium prices, far above what competitors can bear, which further supports its industry crushing gross margin profile.Another intangible advantage worth mentioning (but not necessarily a long-term one) is TSMC’s established relationships with some of the most important semiconductor customers in the world, including Apple, Nvidia, Qualcomm, Google, and AMD. Years of profitable business between them has established TSMC as a “choice supplier” for these firms, making it easier to continue winning business with them year after year.
Management and Finances
TSMC is run by C.C. Wei, a 25-year veteran of the company that took over as CEO in 2018. Under his watch, the company has further expanded its technological and financial lead over nearly all of its competitors while generating excellent financial results. During that time, TSMC has increased revenues at nearly 20% annually, maintained a gross margin profile over 50%, averaged free cash return on capital exceeding 25%, and free cash flow margins close to 40%. Nice!TSMC is also a very disciplined financial company. All of its growth has been internally generated, with almost no meaningful mergers or acquisitions, and only a modest debt-to-equity ratio of 27% (despite tremendous capital spending needs). This is exactly what I like to see.The company is also a dividend payer, currently sporting about a 1.3% yield. TSMC started paying dividends in 2004 and has never reduced them (and usually raised them). Considering the extreme volatility of the semiconductor space, that’s a very impressive track record indeed!
Risks
This one is looking pretty good, but it is not without risks.Close to 90% of TSMC’s current production capacity is located in Taiwan. As most know, Taiwan has long been something of an obsession for China, and fears of an attempted invasion have simmered for a long time. Should the event take place, it could be devastating, not only to an investment in TSMC, but to the world geopolitical and economic environment as well. That’s how important this company is.The firm is taking steps to mitigate this binary risk. 2 new fabs are being constructed in Arizona right now, with both slated to open within the next 2-3 years. A third fab in Japan is projected to open late this year. However, the bulk of production will be within Taiwan for the foreseeable future.Another risk is customer concentration. TSMC’s largest single customer (likely Apple) accounts for a full 25% of 2023 revenue. The top 4 clients generate over 50% of sales. Given the short product cycles in semiconductors, one or more of these clients moving to a competing fab (like Samsung) could cause large disruptions in revenue in a short period of time.Finally, investors need to be aware of the traditionally cyclical chip industry. It is absolutely normal to see wild upward and downward swings in demand in this space, and TSMC will always have up years and down years (the stock will as well). Just be aware of this before buying in.
Conclusion
TSMC is a fantastic company, possibly one of the most important firms in the entire global economy given the prevalence and importance of semiconductors to modern life. It has a wide economic moat, unrivaled technological leadership, and excellent management. It has grown rapidly for 30 years and is showing no signs of slowing down. There are some risks, but, I believe, it is clearly a “green dot” stock.Now the question is: what is a good price for it? I’ve modeled for 16% annual growth, with a 39% free cash margin, and a slightly-higher-than-usual 11% discount rate. That works out to roughly 5,900 New Taiwan dollars per share. Converted back to USD, I get a fair value of $184 per ADR. That’s more or less where the stock trades today. TSMC is a fair buy at current prices, but we will add it to the Watch List and hope for a better price to jump in the near future.More By This Author:Buying Grupo Aeroportuario Del Sureste
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